Banking enables us. It’s Credit allows us to invest and flourish. However, it does this by somewhat arbitrarily creating Debt through the Fractional Reserve Banking Model. How so?

For every $100 you deposit the bank, the bank earns roughly $4 from it and, in the process, creates $900 out of thin air.

Those new to this concept may be a little surprised to hear this, I know, I am.

So, “how do they do that”? Furthermore, is it considered legal or, at the least, even ethical?

What is Fractional Reserve Banking?

Fractional Reserve Ranking is a type of banking whereby the bank does not retain all of a customer’s deposits within the bank. Funds received by the bank are generally on-loaned to other customers. This means that available funds (called bank reserves) are only a fraction (a reserve ratio) of the quantity of deposits at the bank. As most bank deposits are treated as money in their own right, fractional reserve banking increases the money supply, and banks are said to create money.

Novapoly kindly provide us with a great model demonstrating how the banking system can accept a cash or electronic deposit, and, through the practice of fractional reserve banking, create new money (typically electronically) in exponential proportion to the fractional reserve ratio.

It’s not the Central Banks (such as the U.S. Federal Reserve or U.K.’s Bank of England) that create most of the money in circulation, it’s the Commercial banks.

Check out Paul Grignon’s excellent animation for a graphic explanation of the history and mechanics of the this Federal Reserve system:

Is the Fractional Reserve Banking System ethical?

Critics of fractional reserve banking claim that since money creation requires loans from the banking system, people are required to go into debt in order for any new money to be created. By expanding the money supply without actually producing something to show for it you are debasing the means of exchange (i.e. devaluing your currency). It’s generally accepted that the commercial banking system expands the money supply. This is a very powerful privilege. They decide when and to whom they lend to and they don’t even have the underlying commodity to lend. Banks are fallible and are primarily driven by a desire to maximise shareholder profit year-on-year. Many banking executives are incentivised to pump up their short-term bonuses and sensible, business-orientated, long-term planning is a secondary consideration. This is a hugely significant and systemic flaw of our current economic system. So, if banks can create money out of thin air and their motives are not always entirely altruistic or striving for the greater good of mankind, is this sensible?

Fiat money, is paper money, money without intrinsic value and not backed by a tangible asset. You can argue that fiat money combined with the practice of fractional reserve banking does not impose a natural limit on the growth of the money supply, and that this causes inherently unsustainable bubbles in asset and capital markets, which are vulnerable to speculation. Bankers thrive on bubbles and asset trading as they get a cut of the transaction cost even if you the client make a loss. Bubbles are good for business for them, but perhaps this boom-bust cycle is not really in the general interest?

So, why does money created through debt pose a problem? One could argue that since debt, and the interest on the debt, can only be paid in the same form of money, the total debt (principal plus interest) can never be paid in a debt-based, monetary system. The only way to do so would be to endlessly create more money through the same process. For example: if $100 is created and loaned into the economy at 10% per year, at the end of the year $110 will be needed to pay the loan and extinguish the debt. However, since the additional $10 does not yet exist, it too must be borrowed. This implies that debt must grow exponentially in order for the monetary system to remain solvent. Does this mean we, the producers, live in a debt trap and the main beneficiaries are the bankers?

A little bit of history repeating?

Under normal circumstances, many would say that the Fractional Reserve system is quite possibly an adequate, perhaps even ingenious, system of enabling people to gain access to ready money for mortgages and business loans.

However, in a fallible world, are there risks involved in having a such a powerful multiplier on the money supply in the hands of a non-transparent, largely unaccountable few? Are there any previous lessons to be learnt? Well one does come vividly to mind..

In 1914, Germany abandoned the Gold Standard (i.e. the alternative to the Federal Reserve system whereby paper money is backed by real, tangible assets such as gold). It had to pay for the war, and then later when it lost it, the Allied’s reparations under the Versailles Treaty. It had no gold reserves left to back its currency. Thus, the German central bank issued unbacked marks virtually without limit to buy foreign currency for further reparations and to support workers during the Occupation of the Ruhr finally leading to hyperinflation in the 1920s. The travesty that was the Germanic, hyperinflated economy lead to massive civil unrest and unemployment. It crippled any attempt at creating a democracy and eventually paved the way to a strong, but extremist, solution, Hitler.

I know, that is a fairly, “extreme” example, however what we’re seeing in the U.S. today can also be deemed fairly extreme.

Currently, President Obama is creating $100 Billion / month throughout this financial year. He is spending non-existant money like there’s no tomorrow and his friend, Ben Bernanke, Chairman of the Federal Reserve, is happily printing it for him. Running the “Fed”, printing presses hot to a total tune of $1.2 Trillion used to be considered lunacy; not anymore it seems. When you translate this sum into the actual credit created by the Fractional Reserve system, this is actually creating $10 Trillion dollars of DEBT.

Uh oh, folks.

Final Food For Thought

Civilisations rise, civilisations falls, it’s an endless cycle of a “little bit of history repeating”…

The “Tytler Cycle”
(attributed to Alexander Fraser Tytler, Lord Woodhouselee (15 October 1747 – 5 January 1813) a Scottish-born British lawyer and writer.)

A democracy is always temporary in nature; it simply cannot exist as a permanent form of government. A democracy will continue to exist up until the time that voters discover that they can vote themselves generous gifts from the public treasury. From that moment on, the majority always votes for the candidates who promise the most benefits from the public treasury, with the result that every democracy will finally collapse due to loose fiscal policy, which is always followed by a dictatorship. The average age of the world’s greatest civilizations from the beginning of history has been about 200 years. During those 200 years, these nations always progressed through the following sequence:

* From bondage to spiritual faith;
* From spiritual faith to great courage;
* From courage to liberty;
* From liberty to abundance;
* From abundance to selfishness;
* From selfishness to complacency;
* From complacency to apathy;
* From apathy to dependence;
* From dependence back into bondage.

I’m not totally convinced we should get rid of the “private” banks (any non-governmental bank I take it by the PostitiveMoney definition). Our capitalist system has easily surpassed any highly-regulated, socialist model we’ve seen.

However, every system has to be monitored and improved. I do believe the wanton lending at 110% to my young “City” friends in the U.K. or the 1% capital reserve requirement and no credit checks of Fannie Mae in the U.S., is negligent to the verge of criminal.

One difference we have now that Tytler didn’t envision. We have lots of democratic societies now and if one falls, others will surplant it. We have redundancy and mutual system support. Safety in numbers. So, the West still trundles along even with a Communist like Obama leading it into the abyss…